Wednesday, September 24, 2008

Voluntary Mortgage Defaults: A Research Proposal

It is routinely assumed that when a homeowner defaults on a mortgage and the mortgage holder forecloses, the reason was that the homeowner didn't have the money to make mortgage payments. Certainly that's one possible reason, but it is not the only one.

Suppose you buy a $100,000 house with $5000 down and a mortgage for the rest. Further suppose the housing market slumps, as it has, and the value of your house drops to $80,000. You now have a $95,000 debt secured by an $80,000 asset, which means that defaulting on the debt and forfeiting the house gives you a $15,000 gain at the cost of the lender. So it may be in your interest to default even if you could continue to pay.

This only works if you either are in a state where the lender's claim against you is limited to the house or if you have no other assets that a lender would find worth going after. My understanding—readers are invited to correct me if I am wrong—is that in some states the lender has a claim against other assets if you default, in others he does not.

If that is correct, it suggests a simple research project, designed to provide a rough estimate of the fraction of defaults that are, in the sense I have described, voluntary. Compare default rates in states where the lender can go after other assets to default rates in states where he cannot. Of course, the researcher would want to try to control, by the usual statistical measures, for other differences among states that might affect the chance of default.

Has anyone done such an analysis? If not, I offer it as a project for an ambitious scholar interested in a currently hot topic.

11 Comments:

This was precisely the reason given to me (when I bought a house recently) to explain why lenders are now reluctant to do less than 20% down on large loans, even when the buyer's income is easily sufficient to make payments. Apparently here in Northern California people have been walking away from (figuratively) underwater homes.

I'd buy that hypothesis more if there also weren't a credit rating consequence on the homeowner. If I default on my house to supposedly make a 15,000 gain, in your example, I would then only gain if I a) kept the house or b) was able to immediately get more housing for the same price as the original(or the same housing at the new price). But this isn't what happens, the title is kept by the lender, who can then recover losses, and my use of the house hypothetically was worth 4/5 of the down payment (because we don't assume any more payments on the principal have been made).

So, out of the rambling comes the point...I would say that the 15,000 gain would only be worth the cost if you figure the credit rating loss is less than 15,000. I think the difficulty in acquiring a subsequent mortgage to purchase more home for the same original price or the same about of housing at the current price, is most likely more than the 15,000 in your example.

Hi, to paraphrase hip radio callers, long-time reader, first time commenter. I think that CA is one of the "no recourse" states where lenders can't go after other assets. I suspect that people in the "recourse" states aren't taking the lender's recourse seriously though because of the political climate and the incredible amount of confusion about who ultimately owns the loans. My aunt runs a title office in another boom state so I've heard a lot of stories to this effect. So maybe the researcher wouldn't find much difference in default rates after controlling properly for other factors. Or maybe you would. It's definetely a neat simple idea.

I love the way you keep hammering away at issues that are important but undercovered, like the seizure of that cult compound in Texas. Keep up the good work.

Just a few days ago I read something about this, by someone in the industry, saying that even in recourse states the banks often choose to foreclose on the mortgage and have done with it, rather than pursue the far more complicated procedure of getting a judgment against the debtor and then going after all of his assets. I'd link to it except that I can't for the life of me remember where I read it. But if this is true then it would screw up your study.

A Canadian commentator last weekend remarked that "no recourse" was one of the major distinguishing differences in mortgages between US and the rest of the world. Whether or not he knows what he's talking about, I don't know.

I think the point is valid enough to justify the research; consider that many people stay in rental accomodation even when they could afford to purchase. Walking away from an underwater debt retroactively converts payments made into rent.

In Arizona, mortgages on primary residence properties are non-recourse. It's not uncommon for people to walk away from houses they are upside down in, although I don't have the rate. So that's one data point for your analysis.

There's an interesting complicating factor related to tax law. If the bank forgives the remaining debt, whether because the state is a non-recourse state, or because the bank finds it not worth the costs of recovery, the IRS (and maybe the state tax board) will consider the amounto f the loan forgiveness as taxable income.

Personally, I find the practice of "no recourse" mind boggling. Where I live, in Sweden, it is way more strict: Once you take out a mortage, you owe the bank the ammount of the mortage. If the house falls in value, you can of course sell it on the market at a lower price to repay part of the debt, but you will have to continue to pay intrest and principal on the ammount still due.

If you fail to make your payments, the bank ends the credit and requires full repayment within two months. Failing that, the debt is transferred to a federal authority (as with any unpaid debts or bills) which they have the authority to seize any of your assets, including the house, and also to seize a major part of your income directly from your employer until your debts are repaid. While this goes on, and three years after, you are totally banned from any further credit engagements, and you can usually not even get a cell phone subscription.

The result of this is that extremely few people here leave their houses, even during extrene hardships and high intrest rates. People tend to suck it up and cut back on other things, since having to sell your home at a lower price than you paid leaves you with potentially a lifetime of debt. Another effect of this is that people think hard and long before getting into big mortages.